The Risks of Banking

By Sam Mamudi

There have been a number of articles in recent days about the big banks, focusing on the dangers they pose to both themselves and the wider economy.

Perhaps the strongest piece is a Bloomberg editorial which calculates that the biggest banks — JPMorgan Chase (JPM), Bank of America (BAC) and Citigroup (C) — would make a tiny profit (or loss, in the case of the latter two) without taxpayer subsidies. Goldman Sachs (GS), too, derives most of its profit from what they call a taxpayer subsidy:

Neither bank executives nor shareholders have much incentive to change the situation. On the contrary, the financial industry spends hundreds of millions of dollars every election cycle on campaign donations and lobbying, much of which is aimed at maintaining the subsidy. The result is a bloated financial sector and recurring credit gluts. Left unchecked, the superbanks could ultimately require bailouts that exceed the government’s resources. Picture a meltdown in which the Treasury is helpless to step in as it did in 2008 and 2009.

But as James Surowiecki wrote on Tuesday, there may be a limit to just what we can do to limit the risks of a banking blow-up — finance by nature is risk-filled enterprise:

[H]istorically, it’s traditional lending gone wrong that’s led to financial crises. In fact, since the late nineteen-seventies, out-of-control lending led to three different banking crises in the U.S. (the sovereign-debt crisis of the nineteen-eighties, the S&L debacle, and the commercial and business real-estate bubble of the late eighties), even before the housing bubble hit. Disclosure, and limits on trading, are good things. But even simple, open banks are, as history shows, risky.

His solution chimes with one piece of Bloomberg’s advice — ramp up equity capital levels:

Requiring banks to have more equity…would make them reckon with the real risks they’re running. As for transparency, forcing banks to rely more on equity funding might help with that too: they’d probably have to be more transparent, too, in order to win shareholders over. Most important, it would give banks a much bigger margin of error, and make it less likely that taxpayers would end up on the hook when things went wrong.

Take the two pieces together, and it looks like a pretty simple issue: Accept that banking requires risk, but try to contain the potential damage by forcing banks to hold far more equity. This would limit profits and recklessness which eventually should (thanks to smaller balance sheets or spin-offs, for example ) reduce the banks’ size both absolutely and relative to the economy.

Taking a rosy view, one could argue that’s been taking place — profits are lower (even with taxpayer subsidies) thanks in part to greater regulation.

But we’re now more than five years from the financial crisis and the bailouts, and seen passage, if not implementation, of Dodd-Frank — and these suggestions are still framed as, well, suggestions. I don’t see the political will to change — and this Washington Post article doesn’t contradict that view:

Regulators…are encouraged by gains in the banking system that point to continued improvement of a once beleaguered industry.

Testifying before the Senate Banking Committee last week, Thomas Curry, the comptroller of the currency, said conditions at the more than 1,800 banks his agency supervises continue to improve.

Perhaps the pessimism is overstated, but consider that, as the Post acknowledges, the big banks still typically trade below book value. That suggests investors either don’t trust banks’ balance sheets or the ability of banks to avoid another (self-inflicted) crisis, or some combination of both. Even as banks shed jobs and in some cases (UBS, for example) shrink their business, it seems too big to fail is a problem that just won’t go away.

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The blog is written by Ben Levisohn, a former stock trader who has covered financial markets for the Wall Street Journal, Bloomberg and BusinessWeek.